Commodities: Reflation Or Supply And Speculation?

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Includes: AAAU, AGQ, BAR, BNO, CPER, DBO, DBS, DGL, DGLD, DGP, DGZ, DSLV, DTO, DWT, DZZ, GHS, GLD, GLDI, GLDM, GLDW, GLL, IAU, IAUF, JJCTF, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, OUNZ, PHYS, PSLV, QGLDX, SCO, SGOL, SHNY, SIVR, SLV, SLVO, SZO, UBG, UCO, UGL, UGLD, USAI, USL, USLV, USO, USOD, USOI, USOU, USV, UWT, WTID, WTIU, ZSL
by: Ganalytics
Summary

Industrial commodity price rises are more driven by market-specific supply issues than reflationary policies.

Pick-up in inflation expectations stems from rise in these prices, transmitting upward price pressures into precious metals.

Macroeconomic backdrop is very bearish for the industrial commodity complex with USD strength, tariffs, and global industrial slowdown.

Supply issues and optimism won't be sufficient to spur an upward trend, but downside risks are substantial.

I'm looking to the charts for technically confirmed opportunities to enter shorts/fade rallies.

Please Note: This analysis was prepared using end of day data from March 8th, 2019. All indicators and valuations reflect the same.

Quick Take

Despite the popular narrative that the recent rise in industrial commodity prices is due to a shift towards reflationary policy, I believe the predominant impetus lies with supply and speculation. Given the linkage between industrial commodity prices and inflation expectations, this in turn has been transmitted into precious metal prices as well, deceptively providing more fodder for the reflation narrative. With stretched fair valuations and a bearish macroeconomic backdrop, I don't believe the elevated prices are sustainable, and I see the balance of risks weighted to the downside. I am judiciously monitoring the markets for opportunities to fade rallies, but these must be accompanied by confirmation via the charts and technical analysis to enter shorts.

My View

This year has seen a substantial rally in commodity prices from oil and copper to gold and silver. While there is an argument to be made that this stemmed from reflationary policies in the form of Chinese stimulus and a more dovish Fed, I've been arguing that this view is too optimistic. A litany of independent supply issues has confronted many industrial commodities, driving up their prices. As these commodities are fundamental input costs to a variety of the world's products, the rise in their prices has naturally been transmitted into rising inflation expectations. This transmission has broadened the reach of these market-specific supply concerns into a more widespread pick-up in commodity prices, specifically those typically valued as a hedge to inflation (e.g. gold and silver).

On the demand and macro side of the ledger, things are not so constructive. Chances are, if you're reading this article, you are already well aware of the global industrial slowdown and Trump/China tariff showdown. Industrial figures out of China, the EU, and more recently the US are decisively bearish. This is particularly concerning for industrial commodities, whose demand is directly derived from "industry" (e.g. manufacturing, and construction). Add a strong US dollar to the mix, and we are not exactly looking at a promising macro backdrop for commodity prices.

This is not to say that there is no impact of the somewhat reflationary shift by the big players. Fed Chair Jerome Powell's dovish rhetoric has contributed to lower longer-term US Treasury yields, providing some relief in financial conditions and reducing the "opportunity cost" of holding commodities (e.g. precious metals) as an investment, but I'm not totally convinced that further tightening isn't on the horizon if equities continue to froth up from here. China has been putting out mixed messages between further stimulus (tax cuts, infrastructure spending) and continued deleveraging. It's simply far too early to determinatively assess the real economic impact of these perceived policy shifts, so at this point their effects are primarily playing themselves out through a pick-up in sentiment, rather than any substantive impacts to the real economy. As such, I'm of the view that a large portion of market commentary is focusing on the wrong narrative by ascribing the pick-up in industrial commodity prices to the "reflation" trade.

Lastly, as I will discuss further down in the article, commodity valuations already look stretched by most of my metrics of fair value. Thus, a bet on commodities at this stage places a lot of faith in the ability of the supply stories to carry the load while waiting on a fairly nebulous set of policy shifts to take effect. In totality, when I combine the rich valuations with the poor macro backdrop and lack of clarity on the reflationary policies and impacts, I am not a buyer.

Ganalytics

Throughout my analysis, I will utilize indicators, charts, and features from an extensive, data-driven analytics platform I developed, the "Reduction Reports". Instead of just providing vague analysis and relevant context, I will quantify everything we discuss through the Reports' analytics. Rather than simply describing something as "bearish" or "bullish" and leaving it at that, I will tell you how bearish or how bullish on a simple scale of 0 (most bearish) to 10 (most bullish). I won't just tell you I think the price is "cheap" or "rich"; I'll provide 0-10 indicators and actual prices to back that up through a variety of fair value models, ranging from complex multi-factor models derived from many price-driving variables to simpler models like a P/E ratio for an equity index or relative value for a commodity. Of course, markets are not concrete mathematical equations; they are the results of the actions and decisions of the billions of people on our planet and innumerable factors that are out of our control. However, having a rigorous, quantified analysis presented through an easily interpreted framework makes it a lot easier to wrap our heads around them.

Lastly, I break down the markets and express my views through five core concepts, which I define as follows:

  1. Fair Value: What's the "right" price?
  2. Factors: What explains the price?
  3. Drivers: What's the market paying attention to?
  4. Risk: What could happen to the price?
  5. Technical Analysis: What's the market telling you?

Factor: Inventories & Production Balance

The Inventories & Production Balance factor is a good reflection of supply tightness present in the commodity under consideration. Let's start with copper. It's evident from the chart above that copper is experiencing a tight supply environment. Both mining and refining production issues continue to make headlines, and China has drastically reduced its secondary (recycling) production as part of its tariff retaliation and efforts to reduce pollution. However, it would still be hard to reconcile the extreme tightness in visible inventories given the abysmal industrial indicators that we've seen. This leads me to the presumption that the draw has been prompted in some degree by China restocking metals while prices were low. This presumption carries two impacts. First, these stocks would not be visible to the market, so the visible inventory data would suggest a tighter market than if the full picture were apparent. Second, the restocking demand is price sensitive and finite, which is not the type of demand that would propel a continued upward trend in prices.

Similarly, while each of the other industrial metals has its own market dynamics, they all tell stories with a similar ring. Inventories are generally low and production issues have been prevalent, many with ties to the anti-pollution campaign China has been running. Some of these pressures are loosening, but they are certainly a critical factor that has kept metals afloat and well-supported.

Stepping over to oil, optimism stemming from OPEC+ and, more specifically, Saudi Arabia's commitment to curb oil production to whatever degree necessary have lifted oil prices substantially off of their Christmas nadir. Saudi Arabia has more than lived up to expectations thus far, but with demand falling and continued high levels of US shale production, the modest seasonally-adjusted reduction in inventories is not commensurate with the rebound in prices. I will quantify this further in the "Fair Value" section below, but viewed in isolation, I assess that the change in stocks since December warrants about a 2.5% price increase (about $1.25 on WTI).

WTI Crude Oil Inventory & Production Balance Factor

Putting aside the quantitative analysis, given the bearish macro backdrop, the market appears to be placing a great deal of faith in Saudi Arabia to not only "outcut" the continued downward revisions in demand, but also to do so (along with OPEC+) significantly enough to eat into the existing glut. That is a pretty aggressive assumption and leads me to the conclusion that the market is priced for the best, leaving downside risk a far greater exposure than further upside.

Factor: Inflation Hedge

Higher industrial commodity prices broadly increase production costs, which ultimately trickle into inflation expectations. There is also a feedback loop in that industrial commodities are also input costs to their own production, so rising prices put downward pressure on supply and further upward pressure on prices. Thus, rather than evidence of the success of reflationary policy messaging, I argue the primary source of the pick-up in inflation expectations is the pick-up in these industrial commodity prices thanks to the supply issues discussed above. This is particularly evident in the correlation between oil and US inflation expectations in the chart below (purple line is market inflation expectations; orange is WTI crude).

Most prominently impacted by this industrial commodity price transmission into inflation expectations are the precious metals, given their traditional appeal as "inflation-protection" assets. While there is certainly an array of economic negativity and the drop in longer-dated US Treasury yields to point to as well, the rise in inflation expectations explains a good portion of the recent rise in the precious metals.

Factor: Sentiment

My Sentiment factors draw from a wide variety of sources to assess the degree of speculative and investor sentiment built into an asset's price. While most of the industrial commodities' Sentiment factors are nowhere near the levels achieved at their recent peaks in 2017 and 2018, there is a marked pick-up off of the lows established during the year-end market sell-off. I believe this turn in sentiment has contributed an outsized impact on the prices of many of the commodities I've discussed. This jump is most apparent in oil (see chart below). Sentiment is an abstract concept, so it's quite difficult to determine what degree of the shift is due to a correction in excessive bearishness versus OPEC+ optimism (or shale production pessimism). However, given the inventory overhang, continued downward oil demand revisions, and the macro backdrop, it's hard for me to label the bearishness as "excessive" to the level that would prompt such a precipitous rebound without a great degree of OPEC+ optimism playing a prominent role.

Further, it is quite possible that some of the pick-up in sentiment has the "reflationary" shift to thank. To the degree that this is true, I believe it is quite vulnerable to a pullback, as I don't expect any visible impact from the somewhat ambiguous rhetoric and mixed policy positions to become evident in the coming months, and it doesn't take much for markets to shift focus and retrace "yet-to-be-validated" optimism.

Fair Value

It's time to quantify. My fair value models come in a variety of flavors and methodologies, but my preferred metrics are "Multi-Factor" models, which account for a wide variety of price-driving factors, including everything I've discussed above.

For copper, I include two Multi-Factor models. The first, which is fully comprehensive, indicates a fair copper price of $2.616, down towards this year's lows. The "Ex-Sent" model assesses fair value if market sentiment were to return to neutral. While this pegs fair value slightly higher at $2.685, I don't think "neutral sentiment" would be warranted given the backdrop I've laid out, so I'm more inclined to side with the lower fair valuation.

For oil, I include three Multi-Factor models with fair values that range from $44.33 to $51.68. Without getting into the nuances that separate the models, the signal is clear: crude oil is rich and seemingly priced for perfection (and then some).

The precious metals are less overvalued (gold fair value: $1,267-1,308, silver: $14.44-14.98), but this is predicated on sentiment and inflation expectations remaining relatively strong. If oil and the industrial metals drop, I expect them to be a drag on gold and silver as well. This may be somewhat counterintuitive, as the weak industrial commodity narrative is anchored to a weak global economy, which is typically associated with flows into haven assets. However, I see the current transmission mechanism as weak industrial economy dictates low industrial commodity prices, which dictate lower inflation expectations, and thus lower precious metal prices. Add in a US dollar that still appears to be subject to a more hawkish central bank than its competitors, and you have a pretty bearish cocktail for precious metals and commodity prices more broadly.

Wrap-Up

While the perceived shift toward reflationary policies has received much of the credit for the recent rise in some industrial commodity prices, an array of independent supply pressures and expectations seems to be more directly responsible for the rally. At this point, the reflation story is speculative at best, and it will be some time before we have clarity on the actual policies and their impacts. The macro backdrop is decisively bearish in both level and direction, and my metrics of fair value add to a bearish narrative for the industrial commodity complex. My view is that these commodities are priced for perfection and then some, but given the tight visible inventories in some of the industrial metals, it's important to proceed with caution before aggressively fading rallies. I'm maintaining a bearish bias and looking for technical signals to enter shorts.

As industrial commodities are input costs to a wide variety of goods, their price appreciation feeds into inflation expectations. This in turn prompts a rise in precious metals given their desirability as a hedge to inflation. While gold and silver valuations appear more appropriate than the industrial metals, they are predicated on maintaining inflation expectations and sentiment at current levels. Given my bearish view on industrial commodities, I view the balance of risks for these factors as weighted towards the downside as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.